US conditions peak for tax-free M&A

Author: Danielle Myles | Published: 6 Sep 2012
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The US M&A market is primed for use of a bespoke, tax-free sales structure known as a reverse morris trust (RMT).

RMTs’ numerous transaction steps make them notoriously difficult to complete, and they are only applicable in limited circumstances. But, a combination of market conditions mean more corporates are looking at RMTs as a serious possibility.

“A lot of people are looking at these right now,” said Robert Profusek, head of Jones Day’s M&A practice.

Firstly, predictions that 2012 would be a bumper year for spinoffs have proved accurate. Spinoffs are essentially tax-efficient intra-company reshuffles that increase shareholder value, but they are also the first step of a RMT.

Reading between the lines, their announcement is an invitation the market. “It’s a classic case of signalling to the world ‘if you are interested, let us know’,” said Profusek.

After the spinoff, the two major steps to complete a RMT are as follows: a smaller, external company merges with the spin-co; and, the resulting merged company issues more than 50% of its shares to the spin-co’s original parent.

The second factor creating a market ripe for RMTs is shareholder activism. The growing power of activist investors and their preference for so-called pure plays has pushed boards to separate different business groups. Also driving the push towards pure plays is the equity markets not accurately valuing combined companies on a combined multiple-basis.

“Since the global financial crisis, investors aren’t getting the values right,” said another US M&A partner.

Finally, low interest rates in the US (and Asia) means financing for these deals is cheap.

Some companies have shown a penchant for RMTs, most notably Proctor & Gamble. The consumer goods company used the structure to sell part of its Folgers coffee unit in 2008, and planned to do the same for its sale of Pringles before the other party, Diamond Foods, withdrew after becoming the subject of an accounting fraud investigation.

More recently Georgia Gulf and PPG Industries combined via a RMT in a $2.1 billion deal, and there is mounting speculation that Liberty Media’s proposed acquisition of Sirius XM will also use the model.

RMT explained

Perhaps the biggest difficulty of completing a RMT is finding a buyer that is smaller than the target. The size differential means the spin-co is deemed the buyer under Internal Revenue Service (IRS) rules, and its original parent company and shareholders don’t pay capital gains tax.

Despite retaining fewer shares in the merged entity, the external company retains management and board control. But the process is a strain on their share value, shareholder confidence, and post-closing activities. “Integrating a target that is bigger than you can be difficult in execution,” said the US partner.

Since 2001 when the IRS released guidelines clarifying when spinoffs, split-offs and RMTs will be tax-free, it is not strictly necessary to obtain a tax ruling before using one of these deal structures.

This is helpful given an IRS ruling takes between six to nine months. But the extent of IRS requirements, and the tax consequences for spin-co’s parent and shareholders if they aren’t satisfied, means many err on the side of caution.

“Most of the major deals are done based upon a private letter ruling from the IRS. So many of these transactions are conditioned upon receipt of a favourable IRS ruling,” said a New York-based tax partner.